Tuesday, 31 March 2015

Along with revised GDP numbers, we now have GDP per head for 2014 as a whole. (I have
used estimates for the fourth quarter up until now.) Growth in 2014 was 2.17%.
That is certainly an improvement on previous years: 2013 1.03%, 2012 -0.01%,
2011 0.80%, 2010 1.10%. However it is no more than the average growth rate
between 1955 and 2010 of 2.1%.

As charts that I have posted earlier
clearly show, this average of around 2.1% really does reflect what looks like a pretty
constant trend over the past. We have had recessions before, but they were
followed by above average growth: in 1983 GDP per head grew by 4.2%, and in
1994 by 3.8%. So as recoveries go, this one has been terrible.

Eurozone

There are signs that the Eurozone recovery may also be
beginning. If this turns out to be the case, you are sure to read a great deal
about how this is all down to the ECB finally adopting Quantitative Easing. I
suspect you will read rather less about another explanation, which is that
fiscal contraction began to ease off last year, and that this will continue
into 2015. The chart below is from the March 2015 OECD Economic Outlook, so the
2014 numbers should be fairly reliable estimates.

The message in both cases is simple. Fiscal austerity reduces
growth. When fiscal austerity stops, growth can resume. It’s a message that
rather a lot of people who were responsible for the fiscal tightening would
rather you didn’t hear.

Monday, 30 March 2015

Whenever I write a post critical of German views on Eurozone
policy, I get comments which can be paraphrased in the following way. Greece
(and maybe other Eurozone countries) are incapable of governing themselves
properly, and when they get into difficulties Germany has to bail them out, so
it is only reasonable that as a price for this Germany should insist on
imposing changes to the way these countries do things.

To say such an attitude is inherently wrong (wrong in any
possible circumstances) seems to be too strong. The IMF, after all, has played
a very similar role many times. Many may criticise the kinds of reforms that
the IMF has demanded as part of its conditionality, but to suggest that
conditions are never made as part of such a loan package seems unrealistic.

But while conditionality of any kind cannot be ruled out, it
can also go far too far. It should never become imperialism, and the choices of
a sovereign people should be respected and accommodated, not ignored.

It is clear that the Greek government ran up unsustainable
debts, and tried to hide these. As a result, it was bound to default on those
debts. As doing so would exclude it from the markets for a time, it was also
reasonable to lend (not give) Greece money to enable it to gradually rather
than immediately achieve primary balance. Some conditionality to correct any underlying weaknesses in the openness and
accountability of the budgetary process would seem
reasonable in such circumstances.

Contrast that with what actually happened. First the Eurozone
resisted default, and then it was only partial, which meant providing far
larger official loans than were needed. The beneficiaries of this were mainly
the financial institutions (e.g. Eurozone banks) who would have otherwise lost
money. Second, ridiculously severe austerity was imposed, which crashed the
economy and made it much more difficult for Greece to adjust. Third,
conditionality far in excess of what was required is being imposed.

I have argued before, based on very rough and ready calculations
that the fall in Greek GDP since 2010 could be entirely accounted for by fiscal
austerity. This conclusion has now been backed up by rather more rigorous
analysis in a new paper by Sebastian Gechert and Ansgar
Rannenberg. As we both acknowledge, some GDP loss was inevitable because the
deficit had to be reduced (and Greece does not have an independent monetary
policy which could offset the impact of deficit reduction). However, as always,
timing is everything. The paper argues that “most of the costs of fiscal
consolidation could have been avoided by postponing and gradually implementing
it after the recovery of the Greek economy, due to the lower expenditure
multipliers during normal times.”

The delay in default, its partial nature and a degree of
austerity that Gechert and Rannenberg describe as ‘biblical’ and which did such
damage are all acutely embarrassing for the Troika. But instead of criticism being
directed at these governments, we see a narrative that tries to blame what
happened from 2010 onwards on Greece itself, and the Greek people in
particular. The economy has crashed because the Greek people do not work hard,
austerity has not worked because it has not really happened, and there have not
been enough reforms. None of this is true, but the narrative seems largely
impervious to facts. (On reforms, for example, see here.)

All this reminds me strongly of how certain attitudes to
beneficiaries of the welfare state have been encouraged by the UK coalition
government. Rather than admit that unemployment benefits had risen because of
the recession and the absence of a recovery (itself a result of austerity), the
focus became on the personal failings of the unemployed themselves. The media
(TV as well as the tabloids) are still full of examples of supposed ‘welfare
cheats’, but they rarely put such examples into context: how tax evasion is a bigger problem that benefit fraud, for
example.

People do hate the idea of ‘their taxes’ allowing ‘other
people’ to get ‘something for nothing’. In contrast tax evasion does not sound too
different from tax avoidance, which many people do as much of as
they can. Condemning one and ignoring the other may be human nature. What is
clearly wrong is politicians playing on these feelings to misdirect anger away
from their own mistakes, or undertaking unnecessary or even harmful policies to
play to the gallery. A clear case of the
latter is the recent increase in benefit sanctions, which are being applied in
an excessive and unfair way, greatly increasing the use of foodbanks as a
result. That a committee of MPs where the government is in a majority have
expressed grave concerns about the policy just before an election gives an
indication of the scale of the injustice that has been taking
place.

When politicians do this, it is a sign of chronic political
weakness: a desperate attempt to cover up past mistakes. There is a strong
danger that the same dynamic may occur in the continuing standoff between Greece
and the Eurozone. Having encouraged a rhetoric
where a virtuous Eurozone has shown nothing but generosity to a feckless
Greece, politicians feel compelled to live up to that false narrative by acting
tough in negotiations, which does no one any good to put it mildly. When Putin
behaves recklessly to boost his popularity and succeeds, we can blame the lack of press
freedom. When political leaders in the UK or Germany play the same trick, do we
blame the media for playing along or the people for falling for it?

Friday, 27 March 2015

One of Paul Krugman’s first books, Peddling Prosperity, made a distinction between academic
economists and people he called "policy entrepreneurs". These are individuals
who promote particular intellectual positions and ideological policy
prescriptions which have little or no academic support, but which may appeal to
certain politicians.

I
remember it as a great book, and unfortunately one of the main subjects - the
idea that tax cuts pay for themselves - is still current in the US. It remains
the case that this idea has virtually zero academic support, but for whatever
reason - the activities of policy entrepreneurs being one - it still has a
tight hold on the Republican Party.

I
also remember being dissatisfied with the concept of the policy entrepreneur.
It seemed to me that the book failed to situate them in a more general
framework of how different interests influenced policy. Why were policy
entrepreneurs particularly prevalent in economics? Could academics also be
policy entrepreneurs? But that was the social scientist in me speaking. It was
clear that such people existed, and that their influence could be far from
benign.

I
was reminded of all this when someone referred me to Andrew Sentance’s latest piece where he advocates
moving to a zero inflation target. Coupled with George Osborne and David
Cameron proclaiming zero inflation as a great success, a horrible thought
occurred. If these guys were re-elected, might they find the arguments of
Andrew Sentance appealing, and actually go for zero inflation? (In the UK, the
Chancellor sets the inflation target.) Getting rid of inflation completely -
sounds like a vote winner!

Why
is it a horrible thought? Because all the academic discussion has been going in the opposite
direction, for a very good reason. The Great Recession has highlighted the
problems caused by the lower bound for nominal interest rates. That problem
will not go away if that lower bound turns out to be -1% rather than zero. The discussion of secular
stagnation has highlighted how the ‘underlying’ level of real interest rates
has steadily fallen over the last few decades. Put the two together, and you
see that a 2% inflation target may mean that we hit the interest rate lower
bound far too frequently for comfort. A higher inflation target is one way,
although not the only way, of reducing this
problem.

Given
this, calling for a zero inflation target seems perverse. In response, Andrew
Sentance says this: “And the fact that a target of zero inflation may not allow
central banks to easily impose negative real interest rates may actually be a
good thing – protecting savers, who have suffered heavily as a result of very
low interest rates since the financial crisis.” This is just the kind of thing
a policy entrepreneur would say: identify your target interest group, and
appeal to their interests over the common good. A politician who wants to
appeal to savers might think that sounds like a good idea, and before you know
it the policy is in place.

I
suspect things have moved on a little since Peddling Prosperity was published.
The role of think tanks is probably greater. The good ones are a means of channelling
academic research, as in this very recent
discussion of how to enhance real wage growth from the Resolution Foundation (which
I would call excellent if it didn’t have a contribution from me). But they are
matched by others that are effectively the institutional equivalent of policy
entrepreneurs.

One
answer to this problem is
delegation. If you delegate an issue to a non-political body, that institution
is going to be less swayed by the policy entrepreneur, and more influenced by
knowledge and evidence. The independent central bank is an obvious example. It
is interesting that one of the contributions to the Resolution
Foundation volume, from John Van Reenen, calls for a “permanent infrastructure
strategy board”, to improve the level and quality of national infrastructure.
Of course with delegation comes the danger of power without
accountability, and one particular central bank is a good example of that.

Is
delegation the only way we have of protecting ourselves from the policy
entrepreneur? I have one final thought. (The idea comes from Chris Dillow, but he said it on my blog first!). Policy
entrepreneurs exist in part because of sectional interests. The problem arises
if sectional interests drown out evidence based policy. Society as a whole
clearly has an interest in evidence based policy, but one institution that is
well placed to protect society’s interest here is academia. Although - in the UK
at least - academia encourages the dissemination of research, most academics
are always going to value
their research above its dissemination, because that is how internal incentives
work. So maybe the academic sector needs to create a few policy entrepreneurs
of its own, whose mission is to disseminate not their own research, but
research in a whole field. One of two examples already exist -
maybe we should have more of them.

Thursday, 26 March 2015

Chris Giles says today that “there is a gap [between Labour and
Conservatives plans] of more than £30bn a year in public spending by the end of
the decade, at least 1.4 per cent of national income. This is a bigger
political divide seen in any election since the days of Margaret Thatcher.” Chris
is absolutely right to focus on this fact, and it is really important that other
journalists (including those on the political side) do the same. The reason is
that neither Labour nor the Conservatives want to admit this. Labour wants to
appear as if they are being ‘tough on the deficit’ and the Conservatives want
to turn this into a ‘Labour would put up taxes’ election. With all the noise
that these phoney debates throw up, it is important that someone tells people
what the consequences of their vote will be.

Chris may also be right that the
rollercoaster for public spending set out in the Budget (sharp cuts followed by
increases) will not happen. However I think it would be wrong to expect a
smooth ride under the Conservatives either. They will have won an election
based on an initial two years of substantial spending cuts (particularly to
public investment), followed by later years when the overall pace of fiscal
consolidation slowed substantially (in part because of Budget tax cuts). If
that wins them this election, they will want to repeat that pattern. [1]

The term rollercoaster was coined by
Robert Chote, head of the Office for Budget Responsibility. But if the
rollercoaster will never happen, was Robert wrong to use this word? Absolutely
not - in using that term he was doing his job in a very effective way.

As Chris explains, the reason why the
numbers given to the OBR generate a rollercoaster profile is the revised fiscal
rule, which says that there should be (cyclically adjusted) balance within
three years. Like the old rule, this is a rolling target (but now for three years
ahead rather than five), so it means in effect that governments can keep
putting off the date balance is achieved as each year rolls past.

If governments start planning their
fiscal actions with this in mind, the rule becomes largely worthless: it means
reducing deficits mañana. As I explained here,
rolling targets are a good idea because they allow policy to be flexible in the
face of shocks. But rolling targets can also be abused by an irresponsible
government to forever put off deficit reduction.

As I argued here,
there was no good reason for Osborne to switch from a five to three year
rolling target, and good reasons to stick to five years. The move to three
years looked like a political ploy to embarrass the opposition. When
politicians start messing around with fiscal rules for political ends, and
these rules then produce silly results which politicians have no intention of
sticking to, it is important that an independent institution with the words
‘budget responsibility’ in their title calls attention to what is going on.
Robert Chote did that very effectively by using the term rollercoaster.

[1] Where I think Chris is wrong is in
describing plans to decrease debt slowly as risky. The opposite is the case.
With interest rates near their floor, sharp austerity puts the economy at risk
from adverse macroeconomic shocks.

Wednesday, 25 March 2015

And more
on whether price setting is microfounded in RBC models. For macroeconomists.

Why do central banks like using the New Keynesian (NK) model?
Stephen Williamson says: “I work for one of these institutions,
and I have a hard time answering that question, so it's not clear why Simon
wants David [Levine] to answer it. Simon posed the question, so I think he
should answer it.” The answer is very simple: the model helps these banks do
their job of setting an appropriate interest rate. (I suspect because the
answer is very simple this is really a setup for another post Stephen wants to
write, but as I always find what Stephen writes interesting I have no problem
with that.)

What is a NK model? It is a RBC model plus a microfounded model
of price setting, and a nominal interest rate set by the central bank. Every NK
model has its inner RBC model. You could reasonably say that these NK models
were designed to help tell the central bank what interest rate to set. In the
simplest case, this involves setting a nominal rate that achieves, or moves
towards, the level of real interest rates that is assumed to occur in the inner
RBC model: the natural real rate. These models do not tell us how and why the
central bank can set the nominal short rate, and those are interesting questions
which occasionally might be important. As Stephen points out, NK models tell
us very little about money. Most of the time, however, I think interest rate
setters can get by without worrying about these how and why questions.

Why not just use the restricted RBC version of the NK model?
Because the central bank sets a nominal rate, so it needs an estimate of what
expected inflation is. It could get that from surveys, but it also wants to
know how expected inflation will change if it changes its nominal rate. I think
a central banker might also add that they are supposed to be achieving an
inflation target, so having a model that examines the response of inflation to
the rest of the economy and nominal interest rate changes seems like an
important thing to do.

The reason why I expect people like David Levine to at least
acknowledge the question I have just answered is also simple. David Levine
claimed that Keynesian economics is nonsense, and had been shown to be nonsense
since the New Classical revolution. With views like that, I would at least
expect some acknowledgement that central banks appear to think differently. For
him, like Stephen, that must be a puzzle. He may not be able to answer that
puzzle, but it is good practice to note the puzzles that your worldview throws
up.

Stephen also seems to miss my point about the lack of any
microfounded model of price setting in the RBC model. The key variable is the
real interest rate, and as he points out the difference between perfect
competition and monopolistic competition is not critical here. In a monetary
economy the real interest rate is set by both price setters in the goods market
and the central bank. The RBC model
contains neither. To say that the RBC model assumes that agents set the
appropriate market clearing prices describes an outcome, but not the mechanism
by which it is achieved.

That may be fine - a perfectly acceptable simplification - if
when we do think how price setters and the central bank interact, that is the
outcome we generally converge towards. NK models suggest that most of the time
that is true. This in turn means that the microfoundations of price setting in
RBC models applied to a monetary economy rest on NK foundations. The RBC model
assumes the real interest rate clears the goods market, and the NK model shows
us why in a monetary economy that can happen (and occasionally why it does
not).

Tuesday, 24 March 2015

Today it was announced that UK consumer price inflation hit
zero in February. The ONS estimate that we have to go back to the 1960s for the
last time this happened. More importantly, core inflation fell back 0.2% to
1.2%, after 0.1% increases in the previous two months. As Geoff Tily points out, if you take out the 0.2%
contribution from the decision to raise student fees (which are hardly an indicator of excess
demand), then the Governor could be writing a letter to the Chancellor based on
core inflation, and not just the actual inflation rate.

The Chancellor is in election mode and so does not care: in
fact he says zero inflation is good news, and he just hopes no one asks him why
he chose to reaffirm a symmetrical 2% target. For the Bank of England it means
the key question is now should they cut rates? As I noted here,
optimal control exercises on the Bank’s model and forecast say they should, and
I discussed here
why there is an additional strong prudential case for doing so.

The point I want to make now is about survey evidence on
capacity utilisation. I had a number of memorable meetings with various
economists and officials at the Treasury, Bank and elsewhere
when the Great Recession was at its height, but the one that left me most
puzzled was with one of the more academic economists at the Bank of England. It
was at about the time that core inflation started rising to above 2%, despite
unemployment being very high and very little signs of a recovery. At much the
same time survey measures of capacity utilisation were suggesting a strong
recovery, completely at variance with the actual output data. The gist of our
discussion was: what the hell is going on!? It was particularly puzzling for
me, because I had many years before
done a lot of work with survey data of this kind, and back then it seemed
pretty reliable.

The problem with the 2010 period was that it was exceptional,
and so in that sense it was not that surprising to see surprising things going
on. My own pet theory at the time was that the financial crisis had made firms
much more risk averse, which made them less likely to cut prices in an attempt
to gain market share. Move on to today, and things are perhaps a bit less
exceptional. What today’s figures emphasise is that the inflation ‘puzzle’ of
2010/11 has gone away. Levels of inflation are now much more consistent with
substantial spare capacity in the economy. However the bizarre behaviour of the
survey data has not disappeared.

Here is a nice chart from the ONS,
comparing various different measures of spare capacity.

What it shows is that labour market indicators suggest an
amount of spare capacity well outside the ‘normal’ range from the pre-recession
years. In contrast, both hours worked and survey based indicators (the first
six measures) suggest the output gap is quite small, and in one case actually
positive. As this OBR paper shows, survey measures of capacity utilisation
were suggesting a positive output gap as early as 2012.

Faced with this combination of spare capacity in the labour
market and firms reporting its absence, a macroeconomist would suggest it could
be a consequence of high real wages, encouraging substitution from labour to
capital. Firms were fully utilising their capital – hence no spare capacity –
but had hired less labour as a result. However a notable characteristic of this
recession in the UK has been the high degree of labour market flexibility, with
large falls in real wages. One of the more persuasive theories for the UK
productivity puzzle, which I outlined here,
is that we have seen factor substitution going in the other direction.

Back in 2010, I was reluctant to suggest the survey data were
simply wrong, partly because of their past reliability but mainly because
inflation was telling a similar story. On the day that inflation hits zero, I
think the argument that these survey measures are not measuring what we used to
think they measured has become much stronger. But that still leaves an unanswered
question - why have they gone wrong, when they worked well in the past?

Sunday, 22 March 2015

In his novel 1984 George Orwell wrote: “Who controls the past controls the
future: who controls the present controls the past.” We are not quite in this
Orwellian world yet, which means attempts to rewrite history can at least be
contested. A few days ago the UK Prime Minister in Brussels said this. [3]

“When I first came here as prime minister five years ago,
Britain and Greece were virtually in the same boat, we had similar sized budget
deficits. The reason we are in a different position is we took long-term
difficult decisions and we had all of the hard work and effort of the British
people. I am determined we do not go backwards.”

In other words if only those lazy Greeks had taken the
difficult decisions that the UK took, they too could be like the UK today.

This is such as travesty of the truth, as well as a huge insult
to the Greek people, that it is difficult to know where to begin. Let’s start
with the simple statement of fact. According to OECD data, the 2010 government
deficit in Greece was 11%, and in the UK 9.5%. The Prime Minister is normally well briefed enough not to tell
outright lies. But look at this chart you can see why the statement ‘virtually
in the same boat’ is complete nonsense.

The real travesty however is in the implication that somehow
Greece failed to take the ‘difficult decisions’ that the UK took. ‘Difficult
decisions’ is code for austerity. A good measure of austerity is the underlying
primary balance. According to the OECD, the UK underlying primary balance was
-7% in 2009, and it fell to -3.5% in 2014: a fiscal contraction worth 3.5% of
GDP. In Greece it was -12.1% in 2009, and was turned into a surplus of 7.6% by 2014: a fiscal
contraction worth 19.7% of GDP! So Greece had far more austerity, which is of course why Greek GDP has fallen by 25% over
the same period. A far more accurate statement would be that the UK started
taking the same ‘difficult decisions’ as Greece took, albeit in a much milder
form, but realised the folly of this and stopped. Greece did not get that
choice. And I have not even mentioned the small matter of being in or out of a
currency union.

From the Prime Minister, let’s move to Janan Ganesh, FT
columnist and Osborne biographer. He says that Osborne’s
secret weapon is his “monstrously incompetent adversaries”. If only the Labour
party had “owned up to its profligacy in office during the previous decade” it
would have more authority in the macroeconomic debate today. I have written a great deal on this, but actually you can get
the key points from the chart above. If you have a target for government debt which
is 40% of annual GDP, and nominal annual growth is around 4%, you want to aim
for a deficit of 1.6% of GDP. Labour clearly exceeded that, which is why the
debt to GDP ratio drifted up from 30% of GDP in FY 2000 to 37% in FY 2007 (OBR
figures).

A mistake? Yes, particularly in hindsight. Profligacy -
absolute nonsense. The debt to GDP ratio in FY 2007 was below the level Labour
inherited, which does not sound like a profligate government to me. Nor does a
deficit in 2007 that is only about 1% above a long run sustainable level signal
profligacy.

What blew the deficit was the recession. Ganesh acknowledges
that, but says “there was no excuse at all for pretending that a recession was
never going to happen “. This is pure hindsight stuff. In 2007, the consensus
was that the UK was close to balance in terms of the output gap. It is only subsequently that some have tried to suggest,
rather unconvincingly, that 2007 was really a global boom. So Labour was not
pretending anything.

But why this urge for Labour to apologise for what is a
relatively minor misdemeanour which had no major consequences. [1] Because it
plays to the Conservative narrative: their version of history where
Labour was responsible for the mess that the Conservatives had to clean up.
Labour has been forced by mediamacro to buy into the deficit reduction narrative enough as it
is: asking for more is just self-serving political nonsense.

As I explained here, it is really important for the coalition
parties to sustain this narrative, because without it Osborne’s record looks
pretty awful. When people realise that this poor record was not an inevitable
result of ‘Labour profligacy’ or any other mess Osborne inherited, and that to
focus on reducing debt was a choice rather than a necessity, then the
responsibility becomes clear, and support for yet more sharp austerity quickly disappears.
[2]

As for the phrase ‘monstrously incompetent’, I really wonder
what world Ganesh lives in. When I look back at Chancellors of the past, I see
few candidates for this label, and Brown and Darling are not among them.
However what term would you use for a Chancellor that freely chose a policy of
premature austerity, and as a result lost every UK adult and child resources
worth at least £1,500? That unforced error does sound like something worth
owning up to.

[1] The worst that can be said is that, had Labour kept debt at
30% of GDP, they might have felt less constrained in 2009 and undertaken
greater countercyclical fiscal action. But George Osborne argued against the
countercyclical fiscal actions Labour did take in 2009!

[2] That is of course an unsubstantiated conjecture, and the following is not meant to be evidence, because its a small and unrepresentative sample. In
a previous post I mentioned a debate that Prospect magazine organised
between myself and Oliver Kamm. I hadn’t realised until someone pointed it out
(along with a rather biased editorial in that same issue), but readers get a chance to
vote after reading this debate on whether ‘austerity is right for Britain’. At
time of writing, we had 17% voting Yes and 83% voting No.

Saturday, 21 March 2015

People still say to me that the UK or the US had to embark on
austerity, because otherwise the markets would have taken fright at the ‘simply
huge’ budget deficit. How do they know this? Because people ‘close to the
market’ keep telling them so.

What can I do to show that this is wrong? The most obvious
point is that interest rates on UK or US government debt have been falling
since 2008, but the response I sometimes get is that rates have only stayed low
because of austerity policies. So how about looking at one very short period,
around the UK general election of 2010. The election itself was on 6th May, but
Gordon Brown only resigned on 10th May, and the coalition agreement was
published on 12th May.

Labour were proposing a more gradual reduction in the deficit
than the Conservatives, but the Liberal Democrats (the eventual coalition
partners) were during the election closer to Labour. So if there was any
default premium implicit in yields on UK government debt, it should have fallen
between 5th May and 13th May, either because Labour were defeated, or because
the LibDems capitulated on the deficit. Now you may say that the markets were
anticipating a Conservative victory, but even if that is true, on 5th May there
was some doubt about that, which should have been reflected in the price. The
coalition agreement published on 12th May clearly states a commitment to “a
significantly accelerated reduction in the structural deficit”, so that doubt
should have disappeared by then. If there was a default premium in rates before
6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th
May. More to the point, there was no noticeable decline in rates because fiscal
consolidation was going to be greater. Now of course other things may have
happened over these few days to offset any default premium effect, and you can
always spin stories about how markets were concerned about a coalition
government so maybe the accelerated deficit reduction was not going to happen, etc.
But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK
Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping
point’ somewhere: some level of the deficit at which the markets will take fright.
It is then suggested, with reference to the Eurozone crisis, once you reach
that point it is very hard to return, because a vicious circle sets in.
Interest rates rise, making any new debt more expensive to service, which
raises the deficit itself, making default even more likely. As we do not know
where that tipping point is, it is best to stay well away from it by taking
precautionary action before it is reached. The problem with this argument is
that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility
of default. As Corsetti and Dedola explain, the costs of inflation created by
monetising the debt may exceed the costs of default. Markets know that, so they
may still at some point begin to suspect that default could happen. It
therefore follows that the markets could get it wrong: they may begin to
suspect default even when there is absolutely no intention within government to
let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The
markets suddenly panic that the government may default, even though the
government has no intention of doing so. Interest rates start rising on
government debt. But both governments have a Quantitative Easing programme,
which is designed to keep long term interest rates low, so their central banks
respond by buying more government debt. The cost of servicing government debt
does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the
government to take whatever action it wishes to take to reassure the markets.
And unlike the model of Corsetti and Dedola, because there is a recession and a
liquidity trap, the extra money created does not immediately lead to inflation.
[1]

Having your own central bank, which is already undertaking
Quantitative Easing, does not just make a funding crisis a lot less likely, it
also crucially changes the dynamics. If a crisis occurs, the government is not
trapped in a vicious circle. This in turn means that there is no obvious reason
to act in a precautionary way. So why did no one make this point nearer the
time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange
crisis will get you, you need to explain why Paul Krugman’s analysis
is wrong.

Thursday, 19 March 2015

At the beginning of last year, there were many who were
predicting a rise in UK interest rates in 2014. By then UK unemployment had
been falling for many months, and we had had four quarters of solid growth.
However I said that if rates did rise in 2014 it would
be extraordinary. One of the reasons I gave was that there was absolutely no
sign of any increase in nominal wage inflation. I thought it would be
particularly odd if UK rates rose before US rates, given that the UK’s recovery
was lagging a few years.

Unemployment continued to fall rapidly. By June 2014 even the
Bank’s governor, Mark Carney, was giving indications that rates might rise
sooner than some were expecting. US monetary policymakers showed no signs that
they were about to raise rates, and I still thought they should be the first to move, but
I was worried that the MPC was sounding too itchy. Sure enough in August two
MPC members voted to raise rates. But wage inflation showed no signs of
increasing.

Move forward to March 2015, and the prospect of rate increases
seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation,
and also revised down their estimate for the natural rate of unemployment. The
reason is straightforward: despite continuing falls in unemployment, wage
inflation refuses to budge. John Komlos argues that this state of affairs is unlikely
to change anytime soon.

Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes
clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009,
the MPC’s judgement was that the benefits of cutting rates below 0.5% were
probably outweighed by their costs, in terms of the negative impact on
financial sector resilience and lending. With the financial sector now
stronger, the MPC judges there may be greater scope to cut rates below 0.5%.”
It now looks like the Zero Lower Bound (ZLB) may actually be zero.

Haldane goes through in great detail the possible reasons why wage inflation
seems so sticky. Moving to the monetary policy implications, he
talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with
something that I think is even more telling. The chart below shows an optimal
interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.

What it does is confirm a suspicion that both Tony Yates and I
had about the MPC’s current stance. The policy of doing nothing, and waiting
for the inflation rate to gradually converge towards 2%, does not look optimal
even if the Bank’s forecast is completely correct.

The prize for the biggest piece of pure fantasy yesterday must
go to the Chancellor when he said
this: “Today, our goal is for Britain to become the most prosperous of any
major economy in the world in the coming generation, with that prosperity
widely shared across our country.” In terms of a key measure of our long term
prosperity - output per hour worked - we were indeed catching up with the US,
France and Germany until 2008, but since then we
have lost ground as productivity growth has stagnated.

But the fantasy that was most on display yesterday in
commentary about the budget was the idea that the budget deficit was or is our
major problem. I watched Robert Peston go into great detail about just how
large the budget deficit still was (how much we were borrowing every minute -
that kind of thing). I saw Financial Times editor Tony Barber describe what a hole the UK
was in when the Coalition came to power, because the deficit was 11% of GDP. [1]
The implication in both cases is that these numbers are so large we have to immediately
focus on bringing them down.

The hole I remember from 2010 and before was the Great
Recession, which in turn was caused by a financial crisis. They really were
major events, which had major impacts on people, and which therefore demanded
an immediate policy response. The deficit exceeding 10% of GDP had no real impact whatsoever. Interest rates on government debt stayed well below the
level of the previous ten years, and over time fell further.

Here is the growth in GDP per head and the public sector net
borrowing to GDP ratio going back to 1985. In the early 1990s we had a small
recession as we tried to stay in the European Exchange Rate Mechanism at an
overvalued exchange rate. Public borrowing rose to 7% of GDP for two years. But
the economy recovered rapidly following the 1992 depreciation and associated monetary
policy easing, and the deficit came back down. In 2008/9 we had a much larger
recession, and as a consequence the deficit ratio rose rather more. But the key
point was that this rise in the deficit in both periods was largely a response
to the decline in GDP, which helped moderate the recession, and not an immediate problem in itself.

So the idea that in 2010 we were in a deep hole because of the
deficit is just fantasy macroeconomics. It replaces something real (a financial
crisis and deep recession) with something of little immediate consequence. The
problem with living in a fantasy world but taking actions in the real world is
that you make big mistakes, like starting fiscal austerity while still in a
liquidity trap, which has made each UK adult and child on average at
least £1,500 poorer.

For mediamacro, which inhabits the same fantasy world, it means
you ignore the important issues. So we had everyone getting excited about the completely
meaningless fact that the Chancellor had pencilled in an expansion in spending
in 2019 and 2020. (Thank goodness for the OBR, whose use of the word 'rollercoaster' helped expose this circus.) As a result, comment largely ignored
the problem of productivity stagnation, the absence of any expected growth in
net trade, and more generally the persistence of macroeconomic imbalances that
on earlier occasions the Chancellor had said it was vital to correct.

Martin Wolf, who thankfully is very much part of the real
world, said
the Chancellor had “made the best of what is, in truth, not that strong a
hand”. [2] I think Martin is being too generous. The Chancellor asked us to enter a
fantasy world, where the fact that living standards just
might end up higher than when he came into office is regarded as a success,
where employment growth that matches or exceeds output growth is regarded as a
triumph, where finally achieving what are no more than average growth rates in
GDP per capita during what should be a recovery phase is praised, and where
reducing the deficit is all important. It is a shame that too many others seem
happy to share this fantasy.

[1] In financial year 2009 the PSNB was actually 10.2% of GDP.

[2] Chris Giles, Sarah O’Connor and Vanessa Houlder at the FT have a nice graphical summary of key variables that backs this up.

Wednesday, 18 March 2015

What exactly was George Osborne trying to achieve in his
budget? Janan Ganesh says “To his gut, he worries about debt.” But
if reducing the deficit and debt really was his number one priority, then why
spend £5.7 billion over five years increasing the income tax personal
allowance, give £3 billion away to savers, and add a £2.2 billion subsidy for
first time house buyers? It is true that these giveaways were matched, in
theory, by various ‘takeaways’ (mainly a £4.4 billion increase in the bank
levy), but if getting the deficit down was the priority, he could have done the
takeaways without the giveaways.

Everyone knows the answer of course. Winning the next election
is much nearer Osborne’s gut than worries about debt. [1] Much has been made of Labour’s alleged core vote strategy, but
what this and earlier budgets suggest is that the Conservatives have been
following a core vote strategy. There are income tax cuts that mainly benefit the well off, bribes or tax
breaks for the elderly with large savings or pensions, and measures to help those
expecting to buy a house (and consequently those planning to sell them their house). Why do
commentators complain about a core vote strategy for Labour but not the Conservatives?
I’ll leave that as an exercise for the reader.

The Chancellor could not give away more because he needed to
maintain the image of prudence. The sharp cuts in spending after the election
remain: to quote the OBR: “a much sharper squeeze on real spending in 2016-17
and 2017-18 than anything seen over the past five years”. With the OBR
predicting interest rates will be very close to their lower bound over that
period, this still amounts to taking a big risk with the economy. [2] He was
unlucky the last time he tried this in 2010 (and we are on average at least £1,500 poorer as a result), so I
guess he hopes he will get lucky this time.

Is this all because of worries about debt, at a time when
interest rates on debt are very low, and the chances of a debt funding crisis
are non-existent? Even the Economist now suggests that maybe the terrible performance
of UK productivity over the last five years might be a rather more important
issue to focus on. Anna Valero and Isabelle Roland have a nice LSE briefing paper
on this, from which this figure is taken.

The good news is that UK productivity growth has been
relatively strong from 1979 to 2008, perhaps partly because we had some
catching up to do. The bad news is that from 2008 it has been a disaster. Yet
the word ‘productivity’ does not appear in the Budget speech. There are of course small measures
here and there that could be filed under ‘improving productivity’, but it is,
as Frances Coppola notes, peanuts compared to both the size of
the problem and the cuts to public investment undertaken in the first few years
of this government. The LSE paper has some interesting things to say about the
UK’s productivity gap with other countries (poor investment, low firm and
government R&D expenditure, poor management quality), and is fairly critical
of the Coalition government’s policies that could influence this.

It is fairly easy to make fun of Osborne’s references to his
‘long term plan’, and it is tempting to conclude that the frequent repetition
of the phrase means there actually isn’t one. But perhaps it is all very
simple. In this piece for The Conversation I suggest that
maybe there has been a clear plan
all along: to reduce the size of the state over a ten year period, using the
deficit as cover. Here is a chart from the OBR’s forecast document showing the projected share of
government consumption in GDP.

One of the more absurd features of the budget is the kick up in
spending pencilled in for the final year, which appeared to be designed only to
avoid the Labour jibe that we were going back to the 1930s. Otherwise, the idea is to fundamentally reduce the size of the state, and so far it is going to
plan. To finish the job, the Conservatives need to get re-elected, and that
required easing up on austerity from 2012 onwards by either cutting taxes or
not raising them to achieve the original targets. If this is the real long term
plan, then there is no reason to believe that we will not get the promised
second period of severe spending cuts once the Conservatives have won the
election, with of course tax cuts later on to make it all seem worthwhile.

From this perspective, the criticism that Osborne is ignoring
the productivity issue may also be unfair. The Conservatives may genuinely
believe that the best way of increasing productivity is to reduce the size of
the state, and get the ‘government off the backs’ of private enterprise. This theory does not look too good just now, but I guess the lags on this may be long.
Alternatively, of course, they may have got completely the wrong idea about the
role that government needs to play in encouraging growth generally and innovation
in particular.

[1] Am I right to assume that these tax giveaways are
essentially political? Take the increase in the personal allowance for example.
The IFS suggest that aligning the employee national
insurance threshold with the income tax personal allowance would be a better
policy than raising the income tax threshold, both on distributional grounds
(it benefits around 4.6 million low paid workers who pay no income tax), and in
terms of work incentives (as it applies only to earned income). On the Help to
Buy ISA, see John McDermott in the FT.

[2] In passing, it is worth noting that the OBR are also
forecasting inflation coming back to 2% - by 2019! This is despite a view that the
current output gap is pretty small. Some of the capacity utilisation indicators
that go into that estimate do look very strange (tables 3.2 and 3.3).

I found this broadside against Keynesian economics by
David K. Levine interesting. It is clear at the end that he is child of the New
Classical revolution. Before this revolution he was far from ignorant of
Keynesian ideas. He adds: “Knowledge of Keynesianism and Keynesian models is
even deeper for the great Nobel Prize winners who pioneered modern
macroeconomics - a macroeconomics with people who buy and sell things, who save
and invest - Robert Lucas, Edward Prescott, and Thomas Sargent among others.
They also grew up with Keynesian theory as orthodoxy - more so than I. And we
rejected Keynesianism because it doesn't work not because of some aesthetic
sense that the theory is insufficiently elegant.”

The idea is familiar: New Classical economists do things
properly, by founding their analysis in the microeconomics of individual
production, savings and investment decisions. [2] It is no surprise therefore
that many of today’s exponents of this tradition view their endeavour as a natural extension of the Walrasian General
Equilibrium approach associated with Arrow, Debreu and McKenzie. But there is
one agent in that tradition that is as far from microfoundations as you can
get: the Walrasian auctioneer. It is this auctioneer, and not people, who
typically sets prices.

Within this framework, the key price when it comes to Keynesian
economics is the real interest rate. In Real Business Cycle models it is the
real interest rate that moves, by assumption, to ensure that there are no
problems of deficient or excess demand. So these models rule out Keynesian
features by imagining an intertemporal auctioneer.

You might say what is wrong with imagining an auctioneer.
Auctioneers are really just an ‘as if’ story that are meant to approximate how
markets work. However any story of how the real interest rate gets determined
should acknowledge the existence of two critical features of actual economies:
the existence of money and central banks.

When we allow for the existence of money, it becomes quite
clear how the ‘wrong’ real interest rate can lead to a demand deficient
outcome. Brad DeLong takes Levine to task for trying to use a
barter economy and Say’s Law to refute Keynesian ideas, and Nick Rowe turns the knife. What New Keynesian models do
is attempt to remove the intertemporal auctioneer from RBC models. To adapt the
Levine quote above, to replace the auctioneer with a more modern macroeconomics
- a macroeconomics where firms set prices and central banks change interest
rates to achieve a target.

Now your basic New Keynesian model contains a huge number of
things that remain unrealistic or are just absent. However I have always found
it extraordinary that some New Classical economists declare such models as
lacking firm microfoundations, when these models at least try to make up for
one area where RBC models lack any microfoundations at all, which is price
setting. A clear case of the pot calling the kettle black! I have never
understood why New Keynesians can be so defensive about their modelling of
price setting. Their response every time should be ‘well at least it’s better
than assuming an intertemporal auctioneer’.[1]

Levine himself makes no explicit reference to New Keynesian
models. If he had, he would have to acknowledge that in these models temporary
cuts in government spending will indeed reduce output - particularly if
monetary policy is unable to respond. All his stuff about perpetual motion
machines would have to go out of the window. As to the last sentence in the quote
from Levine above, I have talked before about the assertion that Keynesian
economics did not work, and the implication that RBC models work better. He
does not talk about central banks, or monetary policy. If he had, he would have
to explain why most of the people working for them seem to believe that New
Keynesian type models are helpful in their job of managing the economy. Perhaps these things are not mentioned because it is so much
easier to stay living in the 1980s, in those glorious days (for some) when it
appeared as if Keynesian economics had been defeated for good.

[1] What criticisms of Calvo contracts and the like should do
is indicate the limitations of the microfoundations methodology, but another consequence of the New Classical
revolution is that most macroeconomists mistakenly view microfoundations as the only ‘proper’ way
to do macro. There is no epistemological basis for this view.

[2] As Stephen Williamson points
out, these microfoundations would do a pretty poor job at explaining the
behaviour of any particular individual, but instead model common tendencies
that emerge within large groups of individuals.

Tuesday, 17 March 2015

The relationship between
NGDP targets, a higher inflation target and helicopter money

Just suppose that lower oil prices help generate a period of significantly above average growth in the OECD economies over the next five years. We avoid deflation,
but despite more rapid growth modest increases in interest rates keep
inflation at or below target. Even if this happens, the story of the Great
Recession will not have been a happy one. If you compare where we are now to
where we might have been without a financial crisis, there remains a huge gap.
Even if we go a good way to closing that gap over the next five years, this
very gradual recovery will have cost us dear. In some countries (most of the Eurozone) that cost is currently
reflected in high levels of unemployment, while in others (the US) it manifests itself
in real wage stagnation or decline. (The UK is now in the latter group: if you
are bored with hearing this from me, see this
from John Van Reenen.)

Are there lessons to learn from this? You can probably divide
economists into two camps at this point. One group, the ‘supply group’ - which
would include most of those setting monetary policy - tend to think that we
have largely done the best we could under the circumstances. By circumstances,
I mean two related things: a rather surprising increase in inflation during 2011,
and an apparent decline in the ability of the ‘supply side’ of the economy to
grow at the kind of rates we might have expected before the crisis. While the
former is undeniable, the second is conjecture, because we cannot observe the
key driver of long term growth, which is technical progress.

The second group of economists attribute more of the slow
recovery since the financial crisis to deficiency in aggregate demand. I am in
that second ‘demand’ group, and have argued that fiscal austerity is responsible
for a great deal of the slow recovery. Implicit in such arguments is the idea
that had demand been strong, any further increase in inflation around 2011
would have been modest and temporary, which with wise monetary policy need not
have led to any increase in interest rates.

I think most of the demand group also share a view that it
would be a large mistake to shrug off this bad experience as a one-off, or as
something that only occurs every century or so. The ‘one-off’ story could focus
on an unfortunate misreading of the Eurozone crisis: however, while this might
explain the change in attitudes is some important institutions like the IMF, it is less plausible in explaining why policy makers
around the world switched to austerity. The ‘every century’ idea is wrong
because it fails to note the changes that have been brought about by the
widespread adoption of 2% inflation targets, coupled with a view that the
‘natural’ real interest rate is also likely to remain low for some time.

Different members of the demand group have proposed three
different and radical innovations in macroeconomic policy to help avoid this
kind of mistake happening again. These are targeting the level of nominal GDP
(NGDP), raising the inflation target, and some form of helicopter money. Are
these innovations alternatives or complementary to each other?

There are some (notably market monetarists) who seem to argue
that changing monetary policy to NGDP targets is sufficient. My own view is
less optimistic. A clear advantage of NGDP targets (and not its only advantage) is that they would
create expectations of a more expansionary policy during and after the recovery
phase from a recession, but in my view this would not be enough to prevent
liquidity traps happening. This is because I see the problem of the liquidity
trap (nominal interest rates being unable to fall below some lower bound around
zero) as central to why the Great Recession was so prolonged, and episodes where
we experience a liquidity trap as becoming more frequent because the inflation
target (explicit, or implicit within the NGDP target) is low.

Raising the inflation target is an obvious way of reducing the
frequency of liquidity traps. If the natural real interest rate is 2%, for
example, then with a 4% inflation target, the nominal interest rate has much
further to fall before the lower bound is reached than if the inflation target
was 2%. It is important to note that this argument does not preclude adopting a
NGDP target, because any target path for NGDP includes an implicit inflation
target. For that reason, you can view NGDP targets and a higher inflation
target as either complementary or alternatives, where the latter is true only
if you think one device does the required job by itself.

Helicopter money is essentially giving the central bank an
additional instrument - a form of fiscal stimulus. In that sense it is rather
different from NGDP targets or a higher inflation target, because it involves
instruments rather than the objectives of monetary policy. For that reason, in
principle it could be a complement to both the other radical suggestions. In a
way helicopter money is best seen as an alternative to Quantitative Easing, and
there is no reason in principle why QE is not compatible with NGDP targets or a
higher inflation target. It is possible of course that if helicopter money was
shown to be effective in dealing with liquidity traps, then it would make the
case for other radical changes less compelling.

If I’m being realistic, I think that if the first sentence of this post turns out to be true, the
chances of any of these radical changes being adopted before the next liquidity
trap episode are very small. A period of strong growth will be sufficient for
policy makers to pretend that the slow recovery from the financial crisis was
either a one-off or the best that could be done in the circumstances. Instead I
suspect that as the economy moves ever closer to its pre-crisis trend, the
demand group of economists will convince more of the supply group that they
were wrong. This will give greater credibility to the idea that radical changes
to policy are required, and each alternative will receive greater analysis and
probably greater support amongst economists by the time the next liquidity trap
episode occurs.

Thursday, 12 March 2015

You might imagine that the global financial crisis had reduced
the power and influence of finance and those involved in financial markets.
After all, the excesses shown by participants in those markets had caused the
largest recession since WWII. (Not to mention a constant stream of cases of
illegality and mis-selling.) However I wondered yesterday if the opposite might
be true.

This was during a debate
at the Houses of Parliament, in which Jonathan Portes and I were debating
austerity with Roger Bootle and Doug McWilliams. A constant refrain from our
opponents was that (a) the stock of government debt was very large, (b) you
needed the confidence of markets to be able to maintain this level of debt, (c)
markets were fragile beasts, so best take no chances, and (d) therefore we
needed austerity to reassure those markets.

I immediately thought of one of my better posts, where I suggest too many people view
markets like a vengeful god, and those that are ‘close to the markets’ like
high priests. (I couldn’t quite believe it when a member of the audience asked
our opponents about whether they thought some proposal would ‘pass muster with
the markets’.) Now Roger, who is a sensible guy, did agree that default was not
really an issue for the UK, but the danger was rather inflation, if the deficit
or debt became ‘too large’ and markets refused to fund it, so it had to be
monetised. If it seems odd to you that the markets would start worrying about
the monetisation of debt because a large recession increased deficits, but be
quite unconcerned today about the central bank creating money to buy huge quantities
of government debt as part of Quantitative Easing, then your mistake is to
think that the markets are always rational. If they are both fragile and
febrile, as our opponents and others
close to the markets often suggest, it could happen.

Before the financial crisis, it was in the interests of those
involved with financial markets to emphasise how rational they were. No need
for regulation - these are clever people who knew what they are doing. The
crisis blew that argument apart, but instead it created the idea that the
markets could be dangerously irrational: irrationally exuberant at one point,
and irrationally risk averse the next. It also showed how dependent on these
markets the economy had become. Hence the idea of a vengeful god that could
suddenly turn on you for no good reason and who therefore had to be appeased at
every turn.

This kind of argument has a strong emotional appeal,
particularly when the financial crisis is fresh in peoples’ minds. I suspect
that attempts to show that markets are actually pretty rational most of the
time will not work. Instead I’m afraid we have to focus on the high priests. A
truly irrational market could do anything. The problem comes when the high
priests declare that, by being close to the markets, they can discern some
logic to its tantrums. And by a divine coincidence, this logic just happens to fit macro view of the world that the high
priests hold.

For example, we are told that markets worry about large
deficits and require austerity immediately. Never mind that there is no sign of
worry, and that interest rates are falling: markets are fragile and febrile and
could turn at any moment. The high priests, being close to the markets,
understand that. Strangely the high priests never detect any concern that a
persistent recession brought about by austerity might - through hysteresis
effects - permanently damage productive potential, with potentially greater
impacts on the tax base and long term solvency. I guess the high priests
markets had not read that paper.

We are told that Osborne needed to give a clear demonstration
to the markets that he had the political will to bring the deficit under
control, which is why deficit reduction had to be front loaded. It does not
seemed to have occurred to the high priests markets that, given his
desire to reduce the size of the state and win the next election, front loading
austerity is exactly what he wanted to do, even if he had no particular concern
about the deficit. To show a clear conviction to give top priority to reducing
the deficit required him to do something that was politically costly, like
raising inheritance tax.

And do not forget that Ireland and Portugal were constantly
told by those close to the markets that they needed to embark on acute
austerity to ‘regain the trust of the markets’, when in fact what the markets
were looking for all the time was for the ECB to act as a lender of last
resort. I could see
that from my academic ivory tower, but most of those ‘close to the markets’
did not.

The financial crisis may have told us about the power that
financial markets have, and how it is important to understand how they behave.
But the way to do that and to make good policy in the meanwhile is through
economic science, and not to rely on the wisdom of priests. As I said in my
little speech at the debate, the cost of UK austerity in 2010 and 2011 was at
least 5% and probably more like 10% of GDP, numbers which
neither of our opponents challenged. The gods it seems require big sacrifices
nowadays. But if the only reason for making this sacrifice is that the high
priests tell us that this is what the gods require, then I think the time for
enlightenment is well overdue.